LONDON (Reuters) - Middle East equity funds soared in the first half of 2018 after Saudi Arabia got the nod from MSCI for inclusion in its emerging stocks index, while microfinance and short-duration emerging debt funds weathered the bond market shake-out best.

But top-performing emerging market fund managers are cautious about the possible escalation of a trade dispute between the U.S. and China against a backdrop of tightening liquidity.

“There’s a risk that trade tensions go from bad to worse, which could affect global trade, confidence and growth in emerging markets,” said Rob Drijkoningen, co-head of the emerging markets debt team at Neuberger Berman.

“The inclination to strike a deal still seems far off. That means things can get worse before they get better.”

Neuberger Berman’s Short Duration Emerging Market Debt Fund LP68246881 came third in a league table of EM bond funds based on Lipper performance data, after a bruising first half in which only one fund made money.

That was impact investor BlueOrchard’s Microfinance fund LP60076893 which returned 1.8 percent by investing in institutions making loans to low-income groups in emerging and frontier markets such as Cambodia, Honduras and Ecuador.

In this way, the fund supports the development of affordable housing, education, health, agriculture and clean energy.

On average, emerging debt funds lost 5.7 percent, although short duration strategies were not as badly impacted by U.S. yields rising to a seven-year high, a strengthening U.S. dollar and a tightening Fed, which triggered a May selloff in markets such as Turkey, Argentina and Indonesia.

TOXIC COCKTAIL

“You had a toxic cocktail of rates increasing, which puts pressure on total return, and then spreads widening,” said Drijkoningen, adding that short duration is a defensive strategy when U.S. yields are rising by being both low on interest duration and credit duration.

Going into the second half he is focusing on better quality names and reforming countries such as Ghana, Sri Lanka, Indonesia and Mongolia.

He also has close to 10 percent in Turkish dollar bonds, but half of this matures in the next year. “Although the credit profile of Turkey is deteriorating, it is not falling off a cliff and the ability and willingness to pay is still pretty strong in dollars,” he said.

Unconstrained “go anywhere” funds also did well, such as Franklin Templeton’s Emerging Market Debt Opportunities Fund LP60013289, which came fifth.

Portfolio manager Nicholas Hardingham said a combination of off-benchmark positions, shorter duration and avoiding big losers such as Argentinean local currency debt had helped.

He has now added exposure on the back of weakness, seeing value in some Argentinean securities: “We’re positive on their IMF program - the measures they aim to implement give us additional confidence,” he said.

Likewise, the fund has taken some exposure in Indonesian rupiah debt now that market has become cheaper.

Both Hardingham and Drijkoningen thought EM debt fundamentals remained fairly strong, while valuations were attractive relative to high yield.

“The question is what the typical asset allocator will do – if people still want to sell their EM debt holdings there’s only one way things can go,” said Drijkoningen.

In total, emerging bond funds suffered net outflows of $12.2 billion in the first half according to data from research house EPFR Global, compared with net inflows of $43.9 billion over the same period in 2017.

The picture was far rosier in emerging equity funds, which enjoyed net inflows of $47.4 billion versus $42.3 billion a year ago. However, managers still struggled to deliver returns in volatile markets.

SAUDI SIZZLES

But Middle East funds outperformed, taking the top four places in a Lipper league table of emerging equity funds, while Brazil and India funds brought up the rear.

The Saudi index is up 17 percent so far this year, with some $40 billion expected to flow into the market after MSCI’s decision to promote it.

“We continue to find and hold numerous high-conviction names in Saudi Arabia, supported by compelling demographics, an aggressive reform and modernization program, and the inclusion of the market in the leading EM indices,” said Habib Saikaly, manager of the JPM Emerging Middle East Equity fund.

This fund LP60033916 came second in the equity table, returning 14.45 percent. Saikaly added that the larger Gulf markets had benefited from rising oil prices and a stable dollar.

Ashmore’s Middle East Equity fund, which came third LP68256303, also increased its exposure to Saudi Arabia in the first half, targeting banking and healthcare.